Best picks found in the ‘earnings recovery story’ basket

The Goldman Sachs have come up with a new idea for a periodic report. It’s called the Portfolio Manager’s Playbook, and its three main goals are to illustrate themes and scenarios the market is pricing in, provide a starting point for stock selection and help investors trade top-down themes.

Matthew Ross and Tim Toohey say a recovery is priced into stocks, and quality names are toward the stretched end of their valuation ranges. The broker’s basket of “earnings recovery stories" have seen the largest gains: 50 per cent from 2012 lows. Investors seem more willing to pay for cyclical leverage, with these names trading on an average price-earnings ratio of 18.8 times, compared to 10.5 times in mid-2012.

Goldies thinks there’s some room for lower-quality (or deep value) stocks to re-rate further, but substantial gains will depend on a more substantial earnings recovery.

High-quality firms are now trading at multiples 25 per cent above decade averages and the broker thinks there’s downside risk to this segment if confidence builds around a global recovery.

For those seeking income, Goldies suggests the ‘dividend growers’ basket, which offers more attractive dividend yield growth compared to most defensive names (13 per cent versus 4 per cent), for an “only marginally lower (albeit less secure)" grossed up dividend-yield of 6.1 per cent versus 7.6 per cent for defensives.

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Other things to note are that domestic cyclical stocks have seen the biggest re-ratings, with a PE now 15.4 times, 45 per cent higher than their 2012 lows, and outpacing a 30 per cent gain in the ‘developed markets’ basked. Stocks with US dollar revenues and developed markets are still one of Goldies’ preferred top-down exposures because of their US85¢ target for the Australian dollar over the next 12 months and a view US and euro-area growth will accelerate as domestic growth wanes. So it’s supposed to be higher growth with lower earnings risk.

CLSA strategist John Woods sounds like he has a spring in his step. Following the September federal election, confidence appears to have returned, he says. Business confidence is now at multi-year highs and consumer confidence has recovered to levels last seen in the March quarter.

The market also looks to be pricing in confidence, with defensive industrials now no longer trading at a hefty premium compared to cyclical sectors, Woods says. Also, most sectors are trading above their average valuations. “However, one sign that this rally might have more than hot air behind it is that earnings sentiment has finally turned positive. For the first time since April 2011 there have been more earnings upgrades than downgrades. We expect most upgrades to be driven by the top-line with margins forecasts still elevated."

The broker conducted a screen for stocks that have historically shown revenue leverage to economic growth and had reasonable margin forecasts. Many were still trading with price-to-book ratios around 1, and a number offer higher dividend yields than the banks, Woods notes.

CLSA thinks that the recent rise in iron ore prices would be a benefit to
Arrium
and BHP Billiton, via earnings upgrades, even if the renewed confidence in that market doesn’t translate into higher economic growth forecasts overall.

Banks are a bit of both – there’s reason to consider them cyclical plays, but the search for yield has seen them bid higher alongside more traditional defensive names. National Australia Bank is the broker’s preferred bank.

More direct cyclical plays are likely to grab investor attention as confidence builds.
Bradken
,
Fleetwood
,
UGL
, Arrium and
Abacus Property Group
all offer higher yields than the banks.
CSR
also gets the thumbs up. If GDP does start to improve, that spells trouble for stocks with limited sensitivity to the economy and with margins that are already forecast to exceed five-year averages, and especially if they’re trading at a premium valuation. Woolworths, CLSA is looking at you.